When is the 4% rule safe? Interview with Ed Rempel

Today I’m interviewing Ed Rempel for savewithspp.com. Ed has been a Certified Financial Planner for over twenty years, and an accountant for thirty-three years. After building one of the largest financial planning practices in Canada, he partially retired in his fifties to focus on his passion for writing.

On his blog Unconventional Wisdom, Ed recently discussed his very interesting research* which reveals that if you want to withdraw 4% a year from your retirement portfolio without running out of money in 30 years of retirement, you need to hold significantly more equities than bonds in your portfolio. And that’s what we’re going to talk about today. Welcome, Ed.

Thanks a lot Sheryl.

Q: So how do you define a successful retirement for the purposes of your study?A: For the purpose of the study, I defined a successful retirement as providing a reliable income rising with inflation for 30 years. That means you retire at 65 and your money lasts to age 95.

Q: Many financial planners use the 4% rule, which essentially says that you can withdraw $40,000 a year plus inflation for life from a $1 million portfolio. What do you think?A: I have 146 years of data on stocks, bonds, cash, and inflation. I looked back at all those years to see what would have happened in the past if people retired that year, with each type of portfolio – e.g 100% bonds, 100% stocks plus various other permutations and combinations.

I also tested these scenarios with inflation, to see what actually happened in the past. And the surprising result was that the more equities you actually have the safer your portfolio is. My whole blog is about “unconventional wisdom.” I love challenging ideas that most people believe aren’t really true and that’s one of them.

Q: So, to what extent does retirement success link to whether or not retirees follow the common of rule of thumb which suggests that they shouldn’t invest more than 100 minus their age in equities? For example, the portfolio of a 70-year old should include 70% bonds and 30% stocks.A: We call that the age rule and its one of the things I tested in the study. I found that it actually gives you a significantly lower success rate. If you have 70% bonds at age 70, and the bond allocation is growing as you get older, that’s a very low component of stocks. In these circumstances you will have a much lower retirement success unless you withdraw a lower amount of income each year.

Q: And what would the lower amount of income be in your view?A: If you are more comfortable with a conservative 70% bond/30% stock portfolio, I would suggest you use a 3% not a 4% annual withdrawal rate.

Q: Then what is the stock/bond allocation with the highest success rate, which we defined earlier as having enough money to withdraw 4% annually plus inflation, for thirty years?A: The highest success rate will result if you are invested 70% or more in stocks. This is a very heavy allocation. And if you plan to withdraw more than 4% (i.e. 5% or 6% annually) the highest success rate will occur if you have 90% or 100% stocks.

Q: What about bond or GIC investors? What percentage of their accounts can be safely withdrawn so their money will last thirty years?A: I would suggest bond and GIC investors stick with 2.5%. That’s a little bit more than the interest that they’ll get, so they would be encroaching on their principal.

Q: Many financial advisors tell investors to keep cash equal to two years income, to draw on when their investments are down. Will that improve the possibility that these people won’t run out of money?
A: That is another example of “conventional wisdom” that people subscribe to. And I agree it kind of sounds logical, but my study found that holding two years’ worth of cash will not enhance your chances of making your money last for 30 years. In fact, there were a number of cases where keeping cash actually meant investors ran out of money, when without cash they didn’t.

The only possible benefit would be entirely behavioral. For example, if investments go down some people might get scared and cash them in. However, if they have cash they might leave their investments alone and just spend the cash for a little bit. But in general I don’t recommend this because I like to follow what actually works and I found no actual benefit in holding cash to cover expenses for several years after a market downturn.

Q: Based on their risk tolerance then, how would you advise clients or readers who are nervous about holding a high percentage of equities in their portfolio?A: They still need to stay within their risk tolerance. Therefore, even though the study showed a higher amount of equities is safer, and would give them a better retirement, that’s not what I’m recommending that everyone should necessarily do.

Q: So more conservative investors are just going to have to understand they will either need more money to meet their retirement goals or they will have to spend less?
A: Right. Adding bonds gives you a fixed income that reduces volatility that can make you less nervous. But then you have to lower income expectations.

Q: Say that somebody does go with a higher stock allocation, what about the risk if there’s a stock market crash early in their retirement? How much will it throw out the calculations?A: In the study I went back to 146 years, and there were a lot of big market crashes in the last 146 years, to see what actually happened. In actual fact that I found that historically this almost never a factor except in one very clear case for people who retired in 1929. It was actually inflation that eroded buying power over the years.

Q: What’s the biggest mistake people can make if there is a market decline?A: The biggest mistake, in fact, I call it “the big mistake,” is to sell your investments, like sell your equities or switch to more conservative investments, after a market decline. The bottom line is you must be able to stay within your risk tolerance and stay invested in the market, through the inevitable crashes. That’s the only way you’re going to get the retirement income that you want.

Q: My last question, what is your best advice to retired investors, or investors close to retirement, regarding how to structure their portfolios.A: Well the bottom line is to have a proper retirement income plan. You have to think through what the lifestyle is you want to have and how much money you need to support it. And then look at how you are comfortable investing and come up with a plan that gives you what you need. There will be trade-offs, but once you make a proper retirement income plan, then you can have a sustainable income throughout the rest of your life.

Sheryl Smolkin LLB., LLM is a retired pension lawyer and President of Sheryl Smolkin & Associates Ltd. For over a decade, she has enjoyed a successful encore career as a freelance writer specializing in retirement, employee benefits and workplace issues. Sheryl and her husband Joel are empty-nesters, residing in Toronto with their cockapoo Rufus.